3 Reasons Not To Follow A Proven Index Strategy

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 |  Includes: ABT, COP, CVX, JNJ, KO, MMM, MO, PEP, PG
by: Tim McAleenan Jr.

It is entirely possible that the rapid technological innovation of the past twenty years, coupled with the high volatility in the stock market and a 24/7 news cycle, may have led some investors to conclude that buy-and-hold investing is dead and that investors would be better served if they traded stocks more frequently with the hope of maximizing returns beyond what the earnings growth of the major market indices might provide.

I would find this argument persuasive if two conditions were met:

(A) A major market index (in particular, the S&P 500) performed miserably over time, AND

(B) Investors could come up with a reliable trading strategy that out-earned the earnings growth performance of the underlying index.

According to the 2012 Dalbar Study, neither of these conditions hold true. Over the course of 2011, the S&P 500 returned 2.12% with dividends reinvested, while the average equity investor lost 5.73%. It seems foolish to advise the typical investor against adopting a buy-and-hold strategy when the typical investor is not even capable of producing returns equal to the performance of the underlying assets (and thus, the returns that a buy-and-hold investor would earn).

In fact, over the past one year, three year, 5 year, 10 year, and 20 year periods, the average equity investor has underperformed the S&P 500. Buying-and-holding the S&P 500 would deliver better returns than what the average investor actually earned, and the difference becomes more pronounced over time. For instance, the Dalbar Study points out that over the past twenty years, the S&P 500 has returned 7.81% annually, whereas the average equity investor has achieved returns of 3.49% annually.

That difference of 4.32% is significant. A $25,000 investment that returns 7.81% over twenty years will turn into $118,606. A $25,000 investment that returns 3.49% over twenty years will become $50,192. I find these numbers to be statistically significant. The average investor who thinks that he knows better than the market is only performing half as well over long stretches of time. Whatever strategy the average equity investor may have employed over the past twenty years generated less than half of the wealth earned by the S&P 500 investor who did absolutely nothing.

How do I locate my place between these statistics? Because the S&P 500 consists of many companies that I have no desire to own (such as airlines), I try to look to the highest-quality blue chips in the S&P 500. Let's take a look at the earnings growth of some of the companies that comprise the "Who's Who" of blue-chip investing. Here is a chart of the ten-year earnings growth rate for Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), 3M (NYSE:MMM), Abbott Labs (NYSE:ABT), Chevron (NYSE:CVX), and Procter & Gamble (NYSE:PG).

I set my personal goal for 7% earnings growth and 7% dividend growth over long periods of time. Over the past decade, each of these blue chips have been able to grow earnings by at least that rate or higher, and as long as the valuation multiple remains constant, these firms should deliver returns roughly commensurate with the earnings growth rate.

I understand that the S&P 500's 2.92% annual returns over 2001-2011 stretch have led many investors to conclude that buy-and-hold investing is dead. But before abandoning such a strategy, I ask that investors keep this in mind: many stocks were overvalued in 2001. Heck, Coke traded at over 30x earnings that year. That's not a rational price to pay for a mega-cap stock. It's not necessarily the lack of earnings growth that has hurt investors, but rather, the high multiple created by the dotcom bubble that needed time to deflate. Secondly, there might be something of a Lake Wobegon effect at play. Do you think any of the investors that earned 3.49% over the past twenty years considered themselves average or below-average investors? Probably not many. They probably thought that they knew better than the market, and yet the review of this historical stretch indicates a performance that looks pitiful next to buy-and-hold investing. As long as the earnings growth rates of the top blue-chip stocks remain above 7% for indefinite periods of time, I will not hesitate to hitch my fortune to them.

But still, the need for an explanation is in order. If I think that indexing is both easy and likely to produce satisfactory results, why is it that I choose to follow a strategy that consists of purchasing the types of companies mentioned in the list above?

I have three general objections to following an indexing strategy:

1. I have no desire to own many of the companies listed in the S&P 500. I don't want to see $1 or so out of every $100 I invest go into airline stocks. That's simply not what I want to do with my money. It wouldn't take me too long to find 200-300 companies in the S&P 500 that I would have no desire to own a 10+ year basis. There's plenty of retail companies in the S&P 500 that I think are faddish in nature and have weak earnings quality. It would bother me to know that $7 out of every $1000 invested would be going into them.

2. Secondly, I have a personal preference for companies that are strong enough to throw off regular cash distributions that grow every year. I want to limit Mr. Market's ability to cause me long-term harm to the best of my ability. If I own 100 shares of Conoco Phillips (NYSE:COP) and Mr. Market bids the price of shares up to $70 from around $58, then I know that I have a $1,200 paper profit that I can realize if I feel so inclined. And if the stock price falls to $40, I know that I am receiving a $66 dividend that will add 1.65 shares to my account (if I choose to reinvest) so that I can benefit from Mr. Market's dour mood by adding more shares that increases my future dividends and earnings claims at a faster rate. And plus, if and when the stock price recovers to the $58 range, I have the added benefit of those 1.65 shares baked into the new stock price. Stylistically, this is the closest thing I can find to a win-win situation in common stock investing. If you are dealing with excellent companies that increase their earnings and dividends every year like clockwork, then you can realize a capital gain when the price rises or reinvest and acquire a higher claim on future profits when the stock price declines.

3. And the last reason why I do not elect to follow an indexing strategy is because most index funds use market capitalization to determine a stock's size in the portfolio. In some cases, I find this approach to be absolutely nuts. You're essentially buying more of a stock as its stock price increases. If we woke up tomorrow and Altria (NYSE:MO) doubled from $34 to $68, it would command a higher allocation in the construction of an S&P 500 index fund, even though it would still be earning $2.17 per share in profit.

Essentially, I am bothered by the fact that the S&P 500 is a free-float capitalization-weighted index (say that ten times fast!). When a company gets cheaper as its P/E shrinks from 20 to 10, it becomes a smaller percentage of the index. But if the company goes from a P/E of 15 to 35, it becomes a larger part of the index. Buying more of something as it becomes more expensive does not interest me.

I don't mean to suggest that there is something dire about index investing. The good news is that, over long periods of time, the price of shares and market capitalizations generally follow the earnings growth, and that fact alone obviates some of my concerns. In fact, I do think that index investing for a long period of time through a company like Vanguard can fall into the "surest ways to build wealth" category. Nevertheless, I wanted to offer the three reasons why index investing does not appeal to me enough as a strategy to the point where I would actually pursue with my own money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.